Baron Lamfalussy, right, saw trouble coming.

Photographer: Dominique Faget/AFP/Getty Images

'Father of Euro' Knew It Was a Problem Child

Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to the Bloomberg View. Follow him on Twitter at @smihm.
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The obituaries of Baron Alexandre Lamfalussy, the cosmopolitan banker who died May 9, describe him as the “father of the euro.” He led a rather charmed life, fleeing Communist-controlled Hungary as a young man, settling in Belgium, and ultimately becoming general manager of the Bank of International Settlements. A brilliant economist, he was the first president of the European Monetary Institute, the forerunner of the European Central Bank.

But many of the dutiful eulogies failed to note one of his central achievements. Even as he played a vital role in the creation of the monetary union, Lamfalussy understood the fatal flaw at its heart: the absence of fiscal and political union to hold it together. As the euro zone lurches toward another reckoning with Greece, his candid assessment points to the radical reforms that may be needed to ensure the survival of the euro.

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The euro zone's origins go back to the 1950s, when Western Europe began inching toward closer cooperation on a range of issues, beginning with the European Steel and Coal Community in 1953, followed by the Treaty of Rome, which created the European Economic Community, in 1957.

Lamfalussy was among a handful of economists to contemplate some form of monetary integration as well as economic unification. As he noted in 1963, “the organization of common monetary institutions could be of great help in coping with possible balance of payments problems of the Community.”

On the surface, this echoed a similar proposal by his mentor, the Belgian economist Robert Triffin, who argued for a European Reserve Fund. Triffin confidently predicted that “monetary unification would not require, in any manner, a full unification of national levels of prices, costs, wages, productivity, or living standards,” much less a “uniformization of the budgetary, economic, or social policies of the member countries.”

Lamfalussy, however, thought otherwise: "The prerequisite to a successful pooling of reserves is the effective co-ordination of economic policies.”

In the early years, his insight remained an academic point. But as the Bretton Woods regime unraveled in the early 1970s, a handful of policy makers in Europe began pushing for a full-scale monetary union. The Werner Committee, which met in 1970, marked the formal beginning of the process. It led to the creation of the European Monetary Cooperation Fund, an institution more impotent than important.

Lamfalussy's post at the BIS gave him a close-up view of these developments. As he watched failed attempts to bring the exchange rates of the many currencies of the EEC into a semblance of convergence, Lamfalussy became increasingly skeptical that market forces alone could impose the necessary fiscal discipline on errant members of the Community. Without a fiscal and political union, he concluded, it would be next to impossible to create a currency union.

As the Cold War ended, Jacques Delors, president of the European Commission, presided over an eponymous commission to craft a road map to a common currency. Delors deserves credit for seeing a golden opportunity to make the euro a reality in the near future. But Lamfalussy, who served on the commission, seems to have seen farther into the future.

The best account of the Delors Commission can be found in Harold James’s magisterial history of the euro. Lamfalussy comes across as profoundly skeptical of the idea that Europe could have a monetary union without a fiscal union. In the transcripts of the meetings, he dryly dismissed the idea "that market discipline was sufficient to bring about fiscal convergence.” He invoked history, noting that successful monetary unions like the one created by the U.S. in 1789 went hand in hand with a fiscal union.

Lamfalussy ultimately submitted an astute analysis of the problem to the larger committee. It laid out a diagnosis that remains relevant today. Lamfalussy contested the conventional wisdom that the financial markets could “iron out of the differences in fiscal behavior between member countries” by making profligate nations pay higher rates to borrow. 

This was unlikely to succeed, he wrote, because “the interest premium to be paid by a high-deficit member country would be unlikely to be very large, since market participants would tend to act on the assumption that the EMU solidarity would prevent the ‘bankruptcy’ of the deficit country.” 

He went on to argue for “a Community-wide macroeconomic fiscal policy which would be the natural complement to the common monetary policy of the Community.”

But such an arrangement was as unrealistic at the time as it appears to many today.

As Lamfalussy would later recall, “nothing in the report was to be alarmist.” Talk of a fiscal union would scuttle any chance that the report's proposals for a single currency would become reality. Rather, Lamfalussy and other committee members simply harbored the hope that “things would develop in that direction” -- a genuine fiscal and economic union.

Europe, sadly, is still hoping. The unpleasant consequences he feared would ensure without a fiscal union -- an overreliance on monetary policy to deal with problems; divergence, not convergence, in the fiscal health of member nations; and a deep vulnerability to the dysfunctions of individual member states -- have all become clear and present dangers.

If the architects of the euro have a chance of salvaging their monetary union, they will need to do more than engage in extravagant monetary policy. They will need to listen to Lamfalussy.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Stephen Mihm at smihm1@bloomberg.net

To contact the editor on this story:
Max Berley at mberley@bloomberg.net